Steve Hamilton is a Tampa native and a graduate of the University of South Florida and the University of Missouri. He now lives in northern Kentucky. A career CPA, Steve has extensive experience involving all aspects of tax practice, including sophisticated income tax planning and handling of tax controversy matters for closely-held businesses and high-income individuals.

Saturday, February 15, 2014

When Can You Take That Deduction?

Sometimes
the most mundane things can cause a tax issue. For example, an asset must be “placed
in service” before one can claim depreciation. Consider that 2013 was the last
year one could claim 50% bonus depreciation, and you can see how someone would
want that big-dollar asset in service by year-end.

But what
does “place in service” mean?

Let us go
through a couple of examples.

Let’s say
that you purchase a single-family home. You know someone who wants to rent.
With that in mind you purchase the property, incur approximately $10 thousand
in repairs and then verify the credit worthiness of the potential renter. You
are surprised and disappointed with the result, and decide not to rent to that
individual.

It is now the
following year. The next applicant is eligible for Section 8 assistance. HUD
sends an inspector, who unfortunately wants additional repairs before approving
the application. You do the repairs. HUD approves. You have a renter.

The issue
here is that expenses must be associated with a trade or business (or an
income-producing activity) that is up and running in order to be deductible.
Prior to then, the expenses are likely “start up” expenses, which are not
immediately deductible. The classic example is a restaurant “dry run,” which
occur before the restaurant opens to the public. Family and friends are invited
to put the kitchen and service through its paces.

Most
accountants would take the position that the house was placed in service (that
is, its “activity” as a rental had started) when it was available to be rented.
You had a renter lined up. Granted the renter did not pass the credit test, but
there was a house, you were willing to rent the house and someone wanted to
rent the house. Unfortunately, you did not otherwise try to “market” the house,
perhaps by listing it on Craig’s List or advertising in the newspaper.

Oh, by the
way, you did not start depreciation until the HUD renter moved in, which is
year two in our example.

Question: Can you deduct the $10 thousand in repairs?

Let’s go on
to example #2.

There is a
life insurance salesman who specializes in the uber-wealthy. He generally sells
life policies of $10 million or more. He has developed quite the network of
CPAS and other insurance agents. When prospective clients appear he will
charter planes rather than rely on commercial flights. He had a bad experience
when a commercial flight ran late, causing him to miss an important meeting and
costing him a possible $8 million commission.

He decides
to purchase his own plane. He needs to fly nonstop from cost-to-coast, as many
of his clients are on the west coast. He eventually finds a $22 million Bombardier
Challenger 604 that fits the bill. Unfortunately it is closing in on December
31, and he needs that bonus depreciation deduction. Problem is he also wants to
customize the plane. He wants a conference table, for example. He wants to be
able to work while he is flying coast-to-coast.

What to do?
He tells the company that he absolutely positively needs the plane before
year-end. On December 30, he gets the plane. He makes a trip to Seattle for a
business lunch, then to Chicago to meet with another insurance agent. He gets
in that business use.

He then returns
the plane so the modifications can be made. He wants that conference table. He
also wants 20-inch display screens rather than the standard 17-inch screens.
Who wouldn’t?

Question:When would you start depreciating the
plane?

How would I
have handled these two cases? In the first example I am inclined to start
depreciation on the house in year one, the same year that the potential renter
flubbed his credit check. The house was ready for rent, evidenced by have a
potential renter wanting to rent.

And I would
have been wrong. The Court decided that the house was not ready for rent in
year one. It needed repairs, for example. The Court also observed that the
potential renter was lined-up before the purchase of the house. After the
credit check, the landlord did not resort to referrals and other means to rent
the house. Instead she applied for Section 8 approval. Since HUD would not
approve the house until repairs were made, the house could not be placed-in-service
before then.

I understand
the Court’s position, and I disagree with the Court. Unless the landlord bought
the house specifically for Section 8, then HUD’s approval or disapproval sways
me very little. Having a potential renter sways me a lot. Were the repairs
substantial enough to prevent a renter from moving in? We do not know.

The Court also
observed that the landlord did not try “other” means to rent the house, such as
newspapers or Craig’s List. That bothers me. Just about every small landlord I
know rents exclusively by word of mouth and referral. The idea of “advertising”
their duplex or fourplex would be unimaginable, especially given today’s
litigious environment. I have run into this position before on audit, so it
does represent the IRS party line. Can
you rebut the position? You can, but it may require documentation of one’s
efforts to rent the property. In my case, the IRS wanted my client’s referral sources
to document her efforts to obtain a tenant.

And I
suspect that the taxpayer’s decision to delay depreciation until year two may
have been fatal.

What about
the plane? It seems to me that the purpose of a plane is to fly, and that plane
flew by December 31. Unless the flights were not really business-related and
constituted only smoke and mirrors, I would say that plane was placed in
service by December 31.

And I would
have been wrong. The Court decided that the plane was not placed-in-service
until the modifications were made, and the modifications were not made until
the following year.

The Court is
not without basis. IF those modifications were really THAT IMPORTANT to the insurance
salesman, then one could reason that the plane was not ready for use in his
trade or business as an insurance salesman. It was not enough to fly. It was
necessary that he fly with a conference table. I get the nuance.

I do not
think that was it, though. The Court went on to talk about how the salesman had
understated his income by tens of millions of dollars and how he used nominees
to conceal ownership and control of entities from the IRS. He had created false
paperwork to support illegitimate deductions. Me thinks that he had hacked off
the Court, and the Court – seeing an opportunity to disallow millions of
dollars of depreciation – took the opportunity.

I tell you
what I would have recommended to the salesman: do not give the plane back
immediately. Wait three or four months. Use the plane extensively. Then install
the conference table. Tax accountants refer to this as “cool down.”

About Me

Thirty years years in tax practice. It's a long time, and I have seen virtually everything short of the fabled tax-exempt unicorn. I was raised in Tampa, went to school in Missouri, taught at Eastern Kentucky University, lived in Georgia, got pulled to Cincinnati when I married, have in-laws in England and a daughter going to the University of Tennessee. I am not sure where I will wind up next, but I hope there is better weather.